Product Differentiation and Economic Progress

Product Differentiation and Economic Progress

Article excerpt

ABSTRACT: In neoclassical theory, product differentiation provides consumers with a variety of different products within a particular industry, rather than a homogeneous product that characterizes purely competitive markets. The welfare-enhancing benefit of product differentiation is the greater variety of products available to consumers, which comes at the cost of a higher average total cost of production. In reality, firms do not differentiate their products to make them different, or to give consumers variety, but to make them better, so consumers would rather buy that firm's product rather than the product of a competitor. When product differentiation is seen as a strategy to improve products rather than just to make them different, product differentiation emerges as the engine of economic progress. In contrast to the neoclassical framework, where product differentiation imposes a cost on the economy in exchange for more product variety, in reality product differentiation lowers costs, creates better products for consumers, and generates economic progress.

In the neoclassical theory of the firm, product differentiation enhances consumer welfare by offering consumers greater variety, but that benefit is offset by the higher average cost of production for monopolistically competitive firms. In the neoclassical framework, the only benefit of product differentiation is the greater variety of products available, but the reason firms differentiate their products is not just to make them different from the products of other firms, but to make them better. By improving product quality and bringing new products to market, product differentiation is the engine of economic progress. The economics literature has clearly recognized the benefits that product differentiation brings with it in the form of a greater variety of products, but has not recognized the role that the process of product differentiation plays in generating economic progress.

The neoclassical theory of the firm differentiates competitive firms from monopolies (and considers many variants in between), but assumes that the market structure is exogenous, even while demonstrating the advantages to firms of having market power. In contrast to this theoretical world, real world firms can take actions to produce market power for themselves, so market structure is not exogenous. The most effective competitive strategies for firms consist of finding ways to differentiate their products and otherwise give themselves some degree of market power, not minimizing the cost of producing a homogeneous product, as the neoclassical competitive framework suggests. This entrepreneurial element of the competitive firm-which is necessary for the firm to survive- is missing from the neoclassical framework.1

The profit-maximizing strategy that neoclassical theory describes for competitive firms will not maximize firm profits in a real-world competitive environment. Seeking economic profits by gaining market power is the profit-maximizing competitive strategy. This has been recognized in managerial economics textbooks at least since Porter (1980), but product differentiation as a competitive strategy has not migrated into the mainstream of neoclassical microeconomics. Managerial economics focuses on profit-maximizing strategies for firms rather than on implications for the economy as a whole. In microeconomic theory textbooks, pure competition, which is the market structure that maximizes social welfare, rules out product differentiation by assumption.

Neoclassical economics recognizes the advantages of product variety that product differentiation brings with it but also argues that markets with differentiated products do not produce at minimum average total cost. There is a trade-off of higher cost for more variety. But this literature looks at product differentiation in a static framework, ignoring a larger advantage of product differentiation: it brings with it improvements in products that generate economic progress. …